Just How Severe Will the Correction Be?

In recent weeks, hardly a day has gone by without a news headline pointing to a residential mortgage lender or investor that has either closed shop, ceased accepting new applications, reported that it is experiencing a liquidity crisis, or is seeking Chapter 11 bankruptcy protection.

It's as if the residential mortgage-backed securities (RMBS) issuance market was frozen in time, while mortgage investors scrambled to place a price tag on some existing portfolios — particularly those with subprime and adjustable-rate products. The turmoil has caused disruptions among institutions that trade loans on the secondary market.

Hold that thought and consider that the commercial sector has continued to plow forward with record-breaking transaction levels. The National Association of Realtors recently reported that its commercial leading indicator for brokerage activity rose to an all-time record high in the second quarter of this year.

Time to play defense

So the commercial sector appears to be taking the bad news of declining liquidity in the capital markets in stride. This, however, is no reason for investors, borrowers, asset managers and securities issuers to consider the residential sector an entity apart from commercial. It is times like these that require a commercial real estate investor to develop a defensive investment strategy in the event the sector experiences similar disruptions.

Distressed debt has emerged in the residential space, and the fact that industry players cannot place an investment value on some of these assets points to a breakdown in loan underwriting discipline during the previous four years.

Because the commercial market has been behaving in a similar manner — with ever rising values and plenty of low-cost loans for just about any conceivable high-risk deal — there is little reason to believe a commercial market correction would be immune from such disorder.

It is a foregone conclusion among analysts that the days of an uninterrupted rise in property values are all but over, at least for now. But with regard to existing mortgages, all eyes are on the rating agencies whose responsibility is to take a daily temperature reading of loan performance, particularly for deals that were packaged into mortgage-backed securities over the past three years.

So far, these analysts report low instances of delinquencies, minimal defaults, and the availability of sufficient credit enhancements for the real estate-backed bonds they have rated. The analysts present these findings as sufficient safety features to refrain from sounding the alarm of potential investment losses.

Roots of the RTC

The drying up of liquidity for real estate finance in the 1980s led to a disorderly decline in the value of properties and mortgage investments. This event led to the creation of the Resolution Trust Corp. (RTC) by Congress through passage of the Financial Institutions Reform Recovery and Enforcement Act in August 1989.

The market endured another downturn in the late 1990s, but it was much less severe because investors benefited from relative order in the expansion of the high-yield CMBS and CDO markets.

While few expect the inevitable correction in commercial real estate to be as severe as the days when the RTC needed to turn almost $200 billion of non-performing real estate loans into performing loans, or obtain title to the underlying real estate asset, there will surely be an increase in distressed loans.

The power of efficient markets

Private investors who make a living by accurately pricing and purchasing subperforming and non-performing assets will most likely lead the relative order in the absorption of many whole loans and securities affected by the correction. They will do so by efficiently pricing loans on a daily basis, through a global marketplace that can trade loans instantly. The practice is called marking the loans, or securities, to market.

“The prevalence of mark-to-market accounting, credit-default swaps, and other tools of modern finance allows risk to be repriced quickly as conditions change,” Standard & Poor's managing director Mark Bachmann recently noted in a report on the subject. “But paradoxically, this rapid repricing also tends to aggravate short-term instability.”

Bachmann insists that the risk-management and liquidity practices of large financial institutions and industrial corporations do not protect them fully against market volatility.

Still, the theory is that distressed debt likely to emerge from the next commercial real estate correction will not significantly disrupt the marketplace. But bear in mind that until eight months ago, the same point was made regarding the residential mortgage investment market.